Estate Tax Rules

THIS PART OF the lesson is purely by-the-book. The book, in this case, is the IRS code—the one that lists all of your income that gets taxed and all the deductions, exemptions and credits that reduce the amount of your income that gets taxed.

It really doesn't pay to go into too much detail here. For one thing, the tax law gets revised, to a greater or lesser degree, almost every year as Uncle Sam finds new things to tax and new loopholes to close. You'll find the up-to-date figures in:

• Your annual tax forms and the instructions that accompany them.

• The dozens of books written to help you fill out your taxes. The annual tax guides from Ernst & Young, the accounting firm, are consistently the best. You'll find them at any bookstore—priced at well under $20 for a book that runs more than 700 pages.

• Tax preparation software for your computer. TurboTax from Intuit leads the field, with software also available from H&R Block, the tax preparation firm.

• Whomever you hire to help you prepare your taxes. The tax code is so complex that, for most people, money spent on professional tax preparation is well spent.

Wherever you turn for help, there is nothing creative about filling out your tax return. It's all a matter of following the rules. Creativity comes later when we start learning about some of the tax shelters you can put to use. The tax-filing rules are straightforward. Here's some very good advice to get you thinking:

Include all the income you earn on your tax return. Otherwise, you'll be hit with interest and penalties and the odds on your tax return being pulled for an audit go up. The IRS counts a few things as income that might not strike you as being income:

• The premiums on any group life insurance provided by your employer beyond $50,000 in coverage.

• Your personal use of an automobile provided by your employer.

• The value of membership in any club or social organization that your employer provided.

• Gambling winnings.

• Alimony.

Deduct everything you can deduct. Otherwise, you will pay more in income taxes than you must. You can skip the bother of itemizing your deductions and just take the standard deduction. Trouble is, the standard deduction isn't very large—just $7,850 in 2002 for a married couple filing jointly. Most people, with families and fairly active lives, could do better by itemizing deductions. You'll save time taking the standard deduction. But what you really want to save is taxes, not time. Just to sum up, there are deductions for:

• Taxes paid. That includes both property taxes and income taxes paid to state and local governments.

• Certain types of interest paid on borrowed money—mostly having to do with your home.

• Charitable contributions—subject to certain rules.

• Casualty and theft losses to your home and other property above 10% of adjusted gross income.

• Miscellaneous deductions from union dues to the cost of a safe deposit box above 2% of adjusted gross income.

• Money put into a qualified retirement savings plan, such as an Individual Retirement Account or Keogh plan.

Just to show you the wisdom of not tackling your taxes by yourself, the section on all the deductions you might be eligible for covers 127 pages in the latest edition of The Ernst & Young Tax Guide. You don't have to commit all those pages to memory but don't just skip over them, either. An evening spent thumbing through those pages will help get you thinking about deductions you should be taking.

Also, here are a dozen legal tax deductions that might surprise you. This isn't an exhaustive list by any means. The point is to show you that the more you know about the tax code, the more you can cut your tax bill by taking deductions you may not have realized you could take. For instance, you can deduct:

1. The cost of a wig or toupee if you can show it is necessary to your mental health, as opposed to just improving your appearance. 2. The cost of renovating a home to accommodate a handicapped person. That could include everything from making light switches and kitchen cabinets more accessible to installing ramps and widening doorways if the person is wheelchair bound. 3. The cost of buying contact lenses. 4. The cost of removing lead-based paint. 5. The current value of anything you donate to a volunteer fire company. 6. The current value of sporting or recreational equipment donated to a local park or playground. 7. Damage to your home from an aircraft's sonic boom. 8. Damage to your lawn caused by accidental application of a weed killer. 9. Damage to trees and shrubs caused by a blizzard. 10. Passport needed for a business trip. 11. The cost of protective clothing needed in your work--or of a uniform, if it is too distinctive to wear out on the street. 12. Gambling losses--up to the amount of any gambling winnings.

Take all your exemptions. There is one for you, one for your spouse and one for each of your dependents. Your dependents would include your children or anyone else who receives more than half of his or her total support from you. There are further exemptions if either you or your spouse is 65 or over and/or if either of you is blind.

The full exemption for any individual was $3,000 in 2002 but is adjusted each year for inflation. But, be warned that the exemption fades away for those in the higher income levels. Your tax preparer or the instruction book that comes with your tax return will tell you what the phase-out levels are for that year.

Take advantage of all tax credits that apply to you. The tax code is filled with tax credits--which are even better than tax deductions or exemptions. Those deductions and exemptions reduce the amount of your income that is subject to tax. A tax credit reduces, on a dollar-for-dollar basis, the amount of tax you actually owe. Any tax guide will list all the credits in detail and you can learn more about them in the instructions that accompany your annual tax return. Here, in brief, are the most widely-used tax credits:

• Child tax credit. This $600 credit, climbing to $1,000 in 2010, is available for each dependent child under 17. The credit is phased out for upper-income individuals—with the phaseout beginning when income tops $110,000 (married, filing jointly).

• Dependent child care credit. If you pay child care costs and your adjusted gross income (taxable income) is $10,000 or less, there's a credit equal to 30% of the cost of such care. In 2003, the maximum credit climbs to 35% of expenses and the income limit to $15,000.

• Credit for adoption expenses. There is a credit of up to $5,000 for the legitimate expenses of adopting a child. There's a credit of an additional $1,000 if you adopt a child with special needs.

• Credit for the elderly. There's a credit of up to $1,125 for those 65 or older or those permanently and totaled disabled. Generally speaking, the credit only applies to those with taxable incomes under $25,000 with limited social security and pension benefits.

• Foreign tax credit. This would apply if you paid income taxes to a foreign government.

• Hope Scholarship Credit. It covers up to $1,500 of expenses for the first two years of college.

• Lifetime Learning Credit. It is equal to 20% of educational tuition and fees paid for you, your spouse or dependents during a given year. This one is complicated with lots of rules. If you think it applies to you, check in a tax preparation book or tax software or with your tax preparer for details.

MONEY TIP

Review the beneficiary forms for all life insurance and for all your retirement savings plans. Make certain that at your death those assets go to those you want to have them.

BONUS TIP

Beware The Assets That Pass Outside Your Will

ONCE YOUR WILL is drafted and signed, it will cover the disposition of most of your assets. But it won't cover all of them. Disposition of some assets is covered not by your will but by the beneficiary form you signed in connection with those assets. Some examples include:

• Life insurance.

• Individual Retirement Account.

• 401(k) plan.

You signed a beneficiary form when you took out the life insurance or when you created the IRA or 401(k). That may have been years ago and chances are you no longer remember who the beneficiaries are. You may want to leave everything to your spouse. But if you were single when you bought the life insurance, the beneficiaries might be mom and dad.